Thursday, October 1, 2009

Back to Business as Usual?


I hate October in Montreal. It's cold, damp and it starts getting dark earlier as the days shorten up. The only good thing is that hockey season kicks off and it's not November yet - a truly depressing month which the French call "le mois des morts" (Month of the Dead).

October is also when all the market bears come out to growl. On the first day of the month, manufacturing and employment reports pounded stocks. I wonder if anyone bothered reading the manufacturing report because it clearly showed that manufacturing grew in September.

But one sector that keeps getting slammed is the auto sector. September U.S. auto sales dropped back to depressed levels, as the jolt from the government-run "Cash for Clunkers" subsidy program proved to be short lived.

Anyways, it's October and markets sold off today. Will it continue? Who knows? Some are proclaiming that we're starting a 10-year bull market while others are more sanguine, warning that the time for aggressive buying has long since passed and it's time to unwind your trades and take a step back.

I will state it again. There is abundant liquidity and performance anxiety to drive equities much higher, so keep watching to see if they're buying the dips. You'll know things are turning down if the Dow has two consecutive lower weekly closes, which looks highly likely this week (curious to see how the market reacts to tomorrow's jobs report).

Now, let me get to tonight's topic (hat tip Fred and Jorge). Reporting for the FT, John Authers asks Back to business as usual?

A year after the financial disaster of 2008, the search is on for investing’s winners and for its casualties. There are surprisingly few of either.

The sell-off was so indiscriminate that there were few clear-cut winners, apart from bond fund managers and the various “global macro” hedge fund managers who had successfully bet on a big crisis. Then, this spring’s rebound came just in time to stop a consolidation for the fund management industry from turning into the wholesale carnage that many had predicted.

Traditional mutual funds investing in equities had a predictably terrible time. The total equity assets held by US mutual funds, according to Financial Research of Boston, fell from $6,400bn at the end of 2007 to $3,760bn by the end of last year.

But assets have since rebounded to $4,350bn, and surprisingly few mutual funds have closed.

Globally, there were 69,032 mutual funds at the end of last year, according to the Investment Company Institute, the main US trade body for the industry. This was up slightly on the 66,435 funds on offer a year earlier.

What has changed, however, is the way the industry offers funds to the public. While before there was an emphasis on “style discipline”, with funds that were closely tied to a benchmark and that promised to maintain a particular investing style, such as growth or value, now fund groups are offering “absolute return” funds. These are not benchmarked against an index but instead attempt to make a strong return regardless of the market.

In the long run, history suggests that investors are better off in equities; but after last year, letting fund managers go wherever they think they can to avoid a loss appears to be more attractive.

There has been more disruption for the less tightly regulated hedge fund sector. Most indices showed hedge funds actually gaining money during the Nasdaq crash of 2000-02. This was a core element of their appeal, and helped them to gain assets throughout this decade.

But they failed to repeat the trick in 2008, with indices generally showing them losing half as much as the main stock market lost.

According to Hedge Fund Research of Chicago, the average hedge fund dropped 19.8 per cent last year, while hedged equity funds (down 26.7 per cent), and convertible arbitrage funds (down 33.7 per cent) did far worse.

With hedge funds desperately paying down loans and contending with redemptions from investors, there were predictions that as many as half of all hedge funds could be forced to close. But the clear-out has not been anything like that drastic, largely thanks to the market recovery.

According to HFR, 1,471 hedge funds liquidated last year, by far the biggest number on record. Another 668 followed in the first half of this year, but already there are signs of new hedge funds being formed: some 330 new funds were launched in the first half of this year.

“The reality a year later is that the hedge fund industry has contracted by about 10 per cent – from about 10,000 vehicles to about 9,000,” says Ken Heinz of HFR.

More surprisingly, more or less all the strategies hedge funds were using two years ago still appear to be viable. Several, notably convertible arbitrage – the business of finding mispricings in the market for convertible bonds – teetered close to disaster, and suffered more closures than others.

“In general, it seems as though business as usual has returned. Many investors predicted that Global Macro and Commodity Trading Advisors would be the darlings of 2009,” says Christopher Miller, chief executive of Allenbridge HedgeInfo, a London-based hedge fund analyst.

“This has not turned out to be the case. CTAs have lost money and Global Macro has underperformed. Conversely, convertible arbitrage, the most bombed-out strategy from 2008, has bounced back handsomely.”

There is a subtler change at work. Managers are less likely to trust everything to one strategy. Rather, the lesson from last year is to maintain the ability to invest in several different ways, so as to be less exposed to an event that could finish off the strategy.

Clifford Asness, the founder of AQR, one of the most powerful hedge fund groups, said: “I think the lesson is that running a monoline strategy is a dangerous thing to do going forward. There’s no way to guard against that except by diversifying somewhat.”

Another surprise to conventional wisdom has been the resilience of quantitative investing.

One of the first ugly moments of the crisis came in early August 2007 when several of the biggest equity market-neutral funds suddenly lost more than 30 per cent in a matter of days. Some of the most famous names in the investment industry suffered, including Goldman Sachs Asset Management.

Without the managers realising it, many funds that used algorithms to buy undervalued stocks while pairing them with “short” positions in similar stocks that seemed overvalued, had piled into the same few companies. When one fund had to liquidate, suddenly they were all afflicted by sudden falls.

There has been some retreat, but the “quant” model has survived surprisingly unscathed. Rather than attempt to incorporate a model of how others might crowd into a trade, the industry is opting for the common sense solution of turning off the computer and trusting to human judgement when there appears to be a risk of extreme conditions.

“The notion of models that become sophisticated enough to replicate human thought is a pretension of the computer artificial intelligence community,” says Don Putnam of Grail Partners, who was an early pioneer of quantitative investing. “Now it is widely recognised that human beings are more important than just in the R&D cycle of the robot. They actually have to interact with the systems.”

While I agree with many things this article states, especially on correlations in quant strategies being exposed in a liquidity crisis, let's be clear on one thing, after 2008, highly leveraged illiquid strategies are dead. And they're going to remain dead for a long, long time.

As for mutual funds getting into the absolute return space, I am highly skeptical. Any manager worth his or her track record will not stay at some mutual fund when they can set up a hedge fund and collect 2 & 20.

And let's not forget that both hedge funds and mutual funds perform poorly when markets head south. Hedge funds are supposed to hedge, but most of them are just taking leveraged beta bets on the markets. Long stocks, long corporate bonds, long commodities, and they use leverage to juice up their returns.

Only a select few hedge funds are capable of navigating through all market environments and even the best got clobbered last year. Most hedge funds are doing fine this year, but it ain't over 'til the fat lady sings.

And it won't be business as usual for hedge funds. Diane Urquhart sent me a message stating that representative Paul Kanjorski (D-PA) today released three draft bills as part of Congress' financial regulatory reform initiative. The bills, according to Mr. Kanjorski address investor protection, create a federal insurance office and require private advisor registration:

Private Fund Investment Advisers Registration Act

  • Everyone Registers. Sunlight is the best disinfectant. By mandating the registration of private advisers to hedge funds and other private pools of capital, regulators will better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole.
  • Better Regulatory Information. New recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries.
  • Level the Playing Field. The advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.
Nothing like regulatory reform to kill the party on Wall Street. Maybe that's the real reason behind today's market selloff. Whatever the case, get ready for another rocky October.

***UPDATE***

U.S. employers cut a deeper-than-expected 263,000 jobs in September, lifting the unemployment rate to 9.8 percent, according to a government report on Friday that fueled fears the weak labor market could undermine economic recovery.

Also, according to Joseph Stiglitz, the U.S. faces the possibility of deflation for the first time since the Eisenhower administration, a threat that may prompt the Federal Reserve to keep interest rates near zero through next year.

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